The Implications of the Increasing Length of Annual Reports - Coursework Example

Discuss the implications of the increasing length of annual reports Introduction There are recent concerns over the prevailing psychological limitations of information processing alongside expansion of data on accounting communication (Morunga and Bradbury, 2012). There is enormous impact of processing costs on disclosure by use of differential reporting regime. From the perspective of Beattie and Dhanani (2008), financial reporting standards have led to creation of costs and benefits applicable in reporting and for financial reports users. According to Dunstan (2002) studies consider the consequences of adopting International Financial Reporting Standards based on the cost of preparing financial reports due to information load required. Information on market prices is used as a reflection of publicly available knowledge concerning a company. Financial reporting of market prices enhances efficiency through provision of more disclosure despite some anomalies that occur in the process of reporting. Experimental literature supports the fact on displaying financial information such as comprehensive income, which have influence on investor’s decisions. Consequently, financial statistics provide useful facts such as earnings and financial ratios that at times prove more costly to extract since they are never revealed by market prices. However, demand for financial information arises from the requirements posed by pending decision task. Such demand requires some level of information processing capacity that is determined by simplicity in presentation and information load (Deloitte, 2010). Main reasons why annual reports have increased significantly in length According to Hall (2009) sheer volumes of disclosures within International Financial Reporting Standards (IFRS) has substantially increased the length of annual reports (Morunga and Bradbury, 2012). There are adequate results showing the impact of information overload on processing strategies and outcome of annual reports. The increase in length is further attributed to increase in the size of financial section of the entire report. There is substantial increase in the notes explaining the accounts and accounting policies. Information on IFRS reconciliations and accounting policies on transition accounts for nearly over 5% of annual reports despite the items not necessarily required on a continuing basis. Elimination of such transition items still gives space for accounting policies as well as note disclosures under IFRS which consumes close to 20% of total space. Therefore, there is significant proof that different components of accounting policy such as general, IFRS transition, financial instruments as well as critical estimates have significant contribution to the length of annual report. Disclosure and breakdown into smaller categories of accounting policies related to line items for the purposes of ensuring that users of financial statements have adequate understanding of the movements in the balance sheet items contribute to the extensive length of annual reports (The Financial Reporting Council, 2009). There are different categories of disclosures that contribute to complexity of financial reporting. Such disclosures in contemporary financial statements include significant accounting policies, different components of line items, various information concerning the entity, subsequent judgments and reasons that occurs in the process of applying accounting policies as well as management decisions. Such judgments are also accompanied by reasons for the decisions applied during creation of financial statements. There are also assumptions and models concerning disclosures of material information that seem relevant to item calculations within financial statements. These include ranges of values, discount charges, level of growth rates as well as affordable interest rates (Morunga and Bradbury, 2012). Further, the length is determined by sensitivity analysis disclosures that ensures users understand in detail underlying measurement variability of each item within financial statements. There are also descriptions on different internal processes such as risk management policies and practices. This incorporates information concerning disclosure of policies as well as procedures for the management of risks associated with financial instruments. At times, the report includes disclosure of fair value of financial figures that are recorded on the balance sheet by use of different measurement tools. Such reporting involves use of different measurement basis on disclosure of fair value for various items. The measurement basis for instance, involves the use of historical cost for disclosure of fair value of reclassified financial assets (Morunga and Bradbury, 2012). Implications of the length of annual reports to companies and users of the report In the recent past, concerns have been raised about the increasing complexity of annual reports from corporate companies. In this case, there are many points to increasing length owing to details provided by analysts as well as regulations associated with the report. Users of the reports are at the same time echoing concerns on the fact that reports no longer reflect required reality of the underlying business. This is since they consider that key messages are lost amidst lengthy disclosures and applied regulatory jargon. However, such reports are justified in their lengthy nature since they are meant for many different users. This therefore creates some pressure on standard setters and other regulators for the purposes of making the reports meet needs of potential stakeholders. The primary objective of corporate reports is to provide investors with information useful for making informed decision on resource allocations hence appropriate assessment of management’s stewardship (Morunga and Bradbury, 2012). Presenting the reports in complicated language by use of difficult to define terms makes some regulations unduly difficult to understand. However, there is difficulty in eliminating the use of technical language from regulations but possibility of making technical financial language more understandable. In such cases plain language is an option; however, it relies on simple sentence structures where technical terms are necessary. The use of longer reports results into use of inconsistent terminologies where different words are used to explain the same things. For instance, there are various terms used in expressing probability thresholds as per IFRS literature. Such terms include remote, probable, principally, substantially, virtually certain amongst other terms of which many assume the similarity in meaning in the use of such terms in annual reports. Such assumptions can cause considerable confusion amongst users (Financial Services Authority and Financial Reporting Council, 2010). Effective communication of annual reports focuses on simplicity of regulations and use of widely understood language. In some instances, regulations are known to lag behind company operations. This is a wake-up call for companies to focus on communicating crucial information directly instead of using regulatory boxes for the purposes of investors finding easy time in understanding the business. Provisions within financial reports need focus on quality narrative that adequately supplements and compliments used financial digits (Campbell and Slack, 2008). Annual reports normally feature variety of alternative performance measures since at times the terms are not provided for under IFRS. Such issues are prevalent since financial statements fail to reflect the reality behind businesses prompting users to agree on additional measures. There are cases where companies try to reconcile and explain alternative measures used in an annual report, however, there are still cases where users get confused on suspicion that companies are trying to hide crucial information. Application of comparable results in annual reports assist organizations in areas of weaknesses since presentation of the report does not cover some crucial information required by users. In such cases where companies change key performance indicators and segments over time, users feel frustrated since they have difficulty in judging and comparing year’s performances. Changes in presentations should not be linked to cover-up of company’s problem in an area of business. Therefore, authenticity of the report lies in clear presentation of financial figures and not in length of the annual report. For example, the information of the company in text illustration as below can better be communicated through illustration (Oppenheimer & Co., Inc, 2011). Illustration on Communication The company revenues were recorded at £ 1,053 million in the year ending 2008, compared with £ 854 million in previous year 2007; this shows an increase of £ 199 million. The increase as recorded is largely attributed to acquisition of XYZ Plc mid-way through the year at £ 275 million; this was offset by the fall in the value of pound relative to the dollar trading at £ 144 million. Therefore, overall results show an achievement of an organic growth rate of 8%. Alternatively the information could have been presented in chart illustration as shown below; Other Examples from company accounts to illustrate the points In presentation of annual reports for corporate organizations, one key factor of corporate organizations is the maximization of shareholders wealth on the basis of the company reports. In such cases the value of an organization’s annual reports does not entirely consist of price value but also the ideal structure as well as the associated terms. Businesses always have different values owing to different operating assumptions such as payment terms as well as deal structures; however, this is not based on the fact that annual reports use different valuation methods. For instance, Alfred Rappaport introduced a technique in 1980’s for the measurement of value; the technique was referred to as Shareholder Value Analysis (SVA). Such approach utilizes the discounted cash flow approach for evaluating future costs and benefits. Consequently, this technique is utilized for marking changes in the value of any business over a period of time. Different values are applicable in the use of the technique that includes the seven value drivers which are sales growth, operating profit margin, income tax rate, incremental investment in working capital, investment in fixed assets, and required rate of return and continuation of this business that determines this capability. The annual report of Whitbread PLC is utilized in this case to show how these value drivers in a discounted free cash flow model affect the reporting length of the annual report (Whitbread PLC, 2013). Sensitivity Analysis of Whitbread PLC Sensitivity of operating profit margin to shareholder value The data table and graph of the company as recorded in the annual report (Appendix I data table 1) shows how sensitive changes in the operating profit margin are to shareholder value. Using 19.6% as the base operating profit margin when the shareholder value is £3199.51M, the results show that a 1% increase (decrease) in the operating profit margin leads to a 6.2% increase (decrease) in the shareholder value. This seems to suggest that for Whitbread PLC shareholder value is quite sensitive to changes in operating profit. So, Whitbread PLC would do good to concentrate on increasing their operating profit margin (Whitbread PLC, 2013). Sensitivity of required rate of return to shareholder value The data table and graph presented in Appendix I (data table 2) shows the sensitivity between Whitbread PLC’s required rate of return and shareholder value. The report reveals that the firms required rate of return is considered very sensitive to the shareholder value. However, unlike the operating profit margin where a 1% increase/decrease has the same percentage in different directions, the report as indicated reveals that a decrease in the required rate of return has a bigger impact on shareholder value than an increase in the required rate of return. A mere 1% decrease in the required rate of return increases shareholder value by 14.18%. Therefore, the report presents the case of Whitbread PLC as laying emphasis in decreasing their required rate of return (Whitbread PLC, 2013). Sensitivity of sales growth to shareholder value The annual report in appendix I (data table 3) shows how sensitive shareholder value is to changes in sales growth. From the figures in the data table it can be revealed that the sales growth is quite sensitive to shareholder value. However, the percentage changes that a 1% increase and a 1% decrease have on the shareholder value are different; a 1% increase is more sensitive to shareholder value than a 1% decrease in sales. So, Whitbread would do well to increase sales as much as possible as it is a good value driver for shareholder value (Whitbread PLC, 2013). Simultaneous sensitivity analysis The above data table shows the relationship between Whitbread PLC’s required rate of return and operating profit margin under different scenarios. All the shaded boxes show the scenarios where the company can do better than they are doing now. The data shows that the firms operating profit margin and required rate of return are negatively correlated. So, as required rate of return decreases, the operating profit margin increases. This analysis is not enough to suggest that there is a direct relationship between the two variables but only that the two variables move in this manner when applied to the firm’s shareholder value. Shareholder value is maximized at £6160.13.31M in the table when operating profit margin is 25.6% and required rate of return 8.32%. Operating profit margin to sales growth The above data table shows the relationship between Whitbread PLC’s operating profit margin and sales growth with the shaded boxes representing the scenarios where the firm can do better than it is currently doing. The graph shows a positive relationship between these two variables when applied to the firm’s shareholder value. At an operating profit margin of 25.6% and a sales growth level of 15.15%, shareholder value is £5587.17M which is the highest possible figure attainable while staying in the above parameters. So, if the results from the previous data table are coupled with the results from this table then the firm would do better if it decreases required rate of return while increasing their sales growth and operating profit margin figure (Whitbread PLC, 2013). From the illustration the shareholder value according to Thomson One is £2787.70M but the figure obtained from the discounted free cash flow valuation was £3199.5M. This means that the discounted free cash flow valuation is as reported does not present very accurate results. Some of the reasons for these are that the model keeps variables constant. This is not very realistic in the business world as the figures constantly change on a daily basis; keeping figures constant does not guarantee accurate results. But the discounted free cash flow model is quite helpful nonetheless (Holmes et al., 2008). For example, it allows one to see how sensitive shareholder value is to certain aspects of the business under specified scenarios. The results obtained from data tables, sensitivity analysis and simultaneous sensitivity analysis report reveals that the main value drivers for Whitbread PLC are: reduction in the required rate of return, increase in the sales growth rate, and increase in the operating profit margin. Overall, it is quite a good valuation model if all values are correct irrespective of the language used in presentation but it cannot be used in isolation; the current state of the economy for one is one aspect that needs to be considered with this model (ASB, 2009). Conclusion Presentation of financial information is considered important in the process of information processing. In other terms it is referred to as information readability which is essential for presentation of annual report disclosures (Lehavy et al., 2011). The nature of information load also plays a role in level of processing. Subsequently, performance of a task improves based on expansion of information using simplified language. However, decline in performance is realized in the event that the amount of information overwhelms user’s processing capacity within the available time. This study examines the impact of information load within annual reports. In this case, analysts should consider effectiveness of annual reports based on notes included in financial statements as compared to cases where amount of information is diversified in the reports. The findings from the research conclude that individual’s capability to cope with financial information overload is always limited. Therefore, issue on readability should be given a priority. References ASB .2009. Rising to the Challenge. Review of narrative reporting Beattie, V., & Dhanani. A. 2008. Investigating Presentation Change in U.K. Annual Reports. Journal of Business Communication, 45 (2), Campbell, D., & Slack, R. 2008. Narrative reporting: Analysts’ perceptions of its value and Relevance. ACCA research report 104 Deloitte. 2010. Swimming in Words: Surveying Narrative Reporting in Annual Reports. London: Deloitte Dunstan, K. L. 2002. The case for the use of international financial reporting standards in New Zealand: a briefing paper prepared on behalf of the New Zealand Securities Commission. Centre for Accounting Governance and Taxation Research School of Accounting and Commercial Law, Victoria University of Wellington Financial Services Authority and Financial Reporting Council. 2010. Discussion Paper 10/3 Enhancing the Auditor’s Contribution to Prudential Regulation. London: FSA and FRC Hall, M. 2009. IFRS accounting changes bedevil the bottom line. National Business Review, 6 March Holmes, G., Sugden, A., & Gee, P. 2008. Interpreting Company Reports and Accounts. 10th ed. Prentice Hall Lehavy, R., Li, F., & Merkley, K . 2011.The Effect of Annual Report Readability on Analyst Following and the Properties of their Earnings Forecasts. The Accounting Review, 86 (3), 1087-1115 Morunga, M. & Bradbury, M. 2012. The Impact of IFRS on Annual Report Length. Business and Finance Journal, 6 (5), 47-62 Oppenheimer & Co., Inc. 2011. Analyst Day Provides Vision, Repositioning Requires a Longer Term Perspective. http://www.opco.com/ The Financial Reporting Council. 2009. Louder than words. Principles and actions for making corporate reports less complex and more relevant. Viewed at http://www.frc.org.uk/ Whitbread PLC. 2013. Annual report and accounts. Viewed at http://www.whitbread.co.uk/ Read More